Delta in the Value of a Promise

What is a dollar? As far as we can tell, there is no legal definition of what it is, no statement that begins, “The dollar is…” Instead, the dollar is something that is defined by other things. When the Federal Reserve was created by the Federal Reserve Act of 1913, the dollar was basically defined by the amount of gold that had to be kept in reserve to back the currency, or 35 cents of gold per dollar. Theoretically, one could take their currency to Fort Knox and exchange it for gold (although it was illegal to own gold bullion between 1933 and 1974). We’d like to think that Andrew Jackson can be seen peering out from his oval with confidence, knowing that something has his back.

Since Richard Nixon closed the gold window on August 15, 1971, the collateral that backs Federal Reserve notes in circulation is typically US Treasury securities. Section 5103 of the US Code states “United States Coins and currency (including Federal Reserve notes and circulating notes of Federal Reserve banks and national banks) are legal tender for all debt.” In other words, a dollar is a piece of paper backed by the promise of the Federal Reserve to pay you another dollar.

What’s the value of that promise? Without gold tethering the dollar, our answer is: “Compared to what?” Unsurprisingly to anyone who hasn’t been living on Mars lately, the value of that promise has risen in the past two-and-a-half months. Since April, the US Dollar Index, which averages the exchange rates between the US Dollar and six major world currencies (euro, yen, pound sterling, Canadian dollar, Swedish krona and the Swiss franc), was up about 10% through last week. It is no coincidence that the Greek financial crisis broke in full in early April; from that point forward the market has judged that the promise by the Federal Reserve to pay you another dollar is worth more than the promise of the European Central Bank to pay you a euro, or the promise by the Bank of England to pay you a quid. In a party full of ugly girls, the US Dollar is the belle of the ball.

Based on the concept of fiat currency, of course, it is not merely the promise to pay you a dollar that backs the dollar, for the Fed (or the ECB or the BOE) can simply print another. Rather, it is indeed the value of the collateral backing that promise. That, too, is relative. The graph below shows across the yield curve the amount that investors are willing to accept for a sovereign obligation issued by the US, Japan, the United Kingdom and the Eurozone.

Source: Bloomberg

Importantly as it relates to the change in the value of the dollar relative to other currencies is the change in yield across the yield curve that investors have been willing to accept for the sovereign obligations in the yield curves above. The graph below calculates the change, or delta in statistical terms, in yield by maturity for each country from April 5 (the recent peak in US rates) until today. Clearly, the US dollar based rates have generally rallied the most—in absolute and percentage terms. For example, the 10-year Treasury note has rallied 74 basis points, or 19% from its recent peak of 3.99% on April 5. At the other end of the curve, the yield on the 3-month T-bill has fallen 9.4 basis points or 55%. We recognize that this is a simplistic connection to draw, for it does not explain why Japan has lower yields than America—that is mostly related to long-term inflation expectations. But to us this delta in value in such a short term is not about inflation, it is about investors applying a higher value on Uncle Sam’s promise to pay than other countries. Dollar investors should remember the words of Will Rogers: "It takes a lifetime to build a good reputation, but you can lose it in a minute."

Annaly Capital Management, Inc. (NYSE:NLY) manages a portfolio of mortgage-backed securities, and its wholly-owned subsidiaries manage assets for and provide services to institutional and individual investors worldwide. Annaly’s principal business objective is to generate net income for distribution to investors from its mortgage-backed securities and from dividends it receives from its subsidiaries. Annaly has elected to be taxed as a real estate investment trust (REIT).